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M&A Advisor Tip

Flight to quality 

 In M&A, "flight to quality" refers to a phenomenon in which buyers shift their focus to companies that are perceived to be more stable, reliable, and less risky. Flight to quality occurs during times of market uncertainty or volatility. We saw a flight to quality begin after COVID-19, and we continue to see this in the market as economists predict a shallow recession ahead in 2024.   Good companies sell in any market. This shift in focus may result in an increased demand for companies with strong financials, a solid track record, and a proven management team. Companies with weaker financials or uncertain prospects may see reduced demand.

Market Pulse Survey - Q4 2022

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M&A Feature Article

If you pay too much upfront, your advisor might not have enough incentive to sell the business. After all, if they can generate a lot of clients with massive upfront fees, they have a successful revenue stream in and of itself.  On the other hand, if you don’t pay any upfront fee, you might be working with an advisor who’s new to the role and desperate for business. Or it could be a sign you’re working with a budget broker who’s going to take as many listings as they can get, throw them up on some websites, and see what sticks.   As you consider fees, recognize you need a cooperative structure that aligns both party’s interests. To that end, the fee is usually comprised of two main components: A retainer and a success fee.   Upfront or retainer fees According to the 2022-2023 M&A Fee Guide from FIRMEX, 81% of M&A advisors change a retainer. Of those, nearly half (44%) charge a single one-time lump sum and 31% charge a monthly fee (the remainder reported “hourly” or “other”). Of those that charge a single upfront fee, most are in the $26,000 to $50,000 range. Monthly fees typically fall between $5,000 to $10,000 a month.   The M&A advisor (typically an investment banker for businesses in the lower middle market) does a significant amount of advance work, researching, packaging, and getting your business on the market. The retainer ensures they can be compensated for their foundational work. Some advisors (56%) will credit the retainer against the success fee paid at closing.   Success and incentive fees The majority of the fee, however, will usually be structure as a success fee, to be paid only if the transaction hits certain benchmarks. Success is typically determined by final transaction value, but other criteria can apply (see “covered transactions” below).   When setting success fees, there are three main philosophies. According to the FIRMEX survey, 40% of advisors use a Lehman scale (the larger the deal the smaller the fee), 35% charge a flat percentage, and 18% use an accelerated formula (a higher percentage for values above expectations).  Let’s look at how this might work in practice on a transaction with a $10 million benchmark but a final selling price of $12 million. (Note: Benchmarks are a private goal set by the seller and advisor. The business is marketed without a set asking price.)  The Double Lehman or “Modern” Lehman can be structured as follows: 10% on the first $2 million, 8% on the second $2 million, 6% on the third $2M, 4% on the fourth, and 2% on everything thereafter. Using these calculations the investment bank would receive $600,000 for hitting the $10 million benchmark and $40,000 on the extra $2 million in added value.  An accelerator model might be structured at 5% on everything up to the $10 million benchmark and 7% on everything thereafter. In this case, the advisor would receive $500,000 for hitting benchmark and $140,000 on the extra $2 million in added value.   Let’s take it even further. If the business sold for $14 million, you would pay an extra $100,000 to the advisor under the accelerator model. But in this scenario, you would have received $4 million over expectations, resulting in a clear win-win.   Arguably, the accelerator model is more aligned with the seller’s interests. That’s because the advisor gets paid the highest percentage on the “last” dollar versus the “first” dollar tied to the Lehman formula.   Value for fee Each deal is unique. An advisor’s fees can vary depending on the size and complexity of the transaction and certainty to close. As you check their references, ask other clients whether they feel they received adequate value in the process.   If the advisor does a strong job of packaging a business, brings multiple buyers to the table, and negotiates a transaction that meets or exceeds the seller’s goals, they will almost certainly have out-earned their fee.

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